THE OUTLOOK FOR THE S&P
(April, 1999)

"If an equity investment does not have the potential
to have a return greater than a tax-free bond, there is
not much value."

Over the next 10 years we believe that the return on the S&P will be between 2% to 7%. Let's discuss a possible scenario for the S&P going forward from here that might explain why. Let's assume the in the next 10 years we will not have such a perfect world of high economic growth, high productivity, low inflation, low interest rates, and no major world conflicts, and that the three ratios we reviewed on pages 4 through 6, were just 35% lower, still far above their historical averages.

As you can see in the historical average chart, this would still suggest evaluations 15% above the historical average. Let's say that the S&P will sell at 18 times earnings instead of the current 30, 10.25 times cash flow instead of 15.75, and a price to sales ratio of 1.1 instead of 1.75.

By looking at the annual chart below, we can see that if the S&P grows at 7.5% (which is its 35 year average), it will grow from 900 in sales per share in 1999 to 1,726 in sales per share in the year 2008. If we assume a 1.25 times sales at that time (which is the highest price to sales ratio in 30 years, prior to today), the S&P will be selling at 2,157 in year 2008. This means that an increase from its current price of 1,561 to 2,157 in 10 years would generate a compound annual return of 3.29%.

• If we assume 1.1 times sales, the 10 year return would be 1.97%

• If we assume 0.95 times sales, the 10 year return would be 0.49%

• If we assume 0.80 times sales, the 10 year return would be -1.22%

(The historical average on this index has been 0.88 times sales.)

Annual Projections for the S&P YEAR 7.5% ESTIM'D S&P SALES ASSUME 1.25 TIMES SALES CURRENTLY SELLING AT COMPOUNDED YEARLY RETURN 1999 900 1125 1561 -27.93% 2000 968 1210 1561 -11.96% 2001 1040 1300 1561 -5.92% 2002 1118 1397 1561 -2.74% 2003 1202 1502 1561 -0.77% 2004 1292 1615 1561 0.57% 2005 1389 1736 1561 1.53% 2006 1493 1866 1561 2.26% 2007 1605 2006 1561 2.83% 2008 1726 2157 1561 3.29%

Obviously, if an investment does not have the potential to have a return greater than a tax-free bond, it would suggest that there is not much value. For those people who feel that indexing is an easy way to get a 15% to 20% return over

the next 10 years, we believe that the S&P index is going to be a major disappointment. To achieve these types of returns would require an assumption in the growth rate of both sales and earnings that the S&P has never achieved in its history. At these levels, only if you are willing to look out at least 25 years, could you expect a return on the S&P over 12%.

A modern day example that shows this is possible is Japan's major index, the Nikkei. In 1989, it peaked at 40,000 yen. People thought that it could only go one way...up! The fact is that at the end of 1998, nine years later, the Nikkei index hit a low of 12,879. This is a decline of 67.80% over nine years, or on a compounded basis, it is a _11.82% return. Even in March of 1999, the Nikkei index is only selling at 15,591. This type of decline brings to mind a statement from Benjamin Graham, "the price you pay for an investment determines its return".

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